The Europeanization Of U.S. Utilities, Part 2

Includes: D, DUK, SCG, SO
by: George Fisher

Blackout: A period during a massive power failure when the lack of electricity for illumination results in utter darkness except from emergency sources, as candles. This is a definition of a blackout and is important as Europe's most influential utility leaders predicted this event for both the UK and most of Europe. Why should US investors care if the lights go out in London? Because the US is heading towards the same type of events as we continue down the same power-generating road as our European counterparts.

And what road is that, you ask? The road where base load power generating is replaced by intermittent load to the equilibrium-tipping condition whereby base load power is insufficient to keep the light on when the sun does not shine and the wind does not blow. Additional information can be found in Part 1 from last March.

Last week, utility leaders in Europe met to continue their warning of potentially severe problems. As reported on CNBC, the following are a few quotes:

Peter Terium, Chief Executive of German Electric Firm RWE AG (OTCPK:RWEOY):

"We want to send an a SOS to Europe, not for the companies, not for the sector, but for Europe as a whole. A prosperous society cannot be prosperous without proper energy infrastructure and our infrastructure is in jeopardy", Terium told CNBC in Brussels.

Warning that Europe could face power blackouts if the economy in Europe recovered but energy provision remained inadequate, Terium warned that energy companies were closing power plants across the continent "that are technically and environmentally very efficient, but we're shutting them down because the system does not allow us to economically operate those plants."

Fulvio Conti, chief executive and general manager of Italian electricity firm ENEL (OTCPK:ENLAY):

"We have contrasting regulations coming from Europe and from member states that are colliding and most of the markets are seeing an increase in prices for the consumer and no profits whatsoever for the industry, that makes no sense at all,"

"We want to eliminate subsidies," he said on Friday. "Too many subsidies are being given on intermittent renewables, too many to local coal and all of these are [leading to] a disaster. The decision to promote non-mature technologies and renewables through subsidies is creating this very peculiar situation where citizens are paying a higher price, the industry is recording no profits and no investments are being made."

It is not just the industry leaders that are concerned. According to the Telegraph, the German Economy Minister today expressed anxiety that the country's shift away from conventional fossil fuel and nuclear power will leave a shortfall of electricity this winter. In addition, the European grid operators have announced a substantial increase of 50% on the tax levied consumers for alternative energy subsidies.

According to a recent study from the British consulting firm Capgemini Group, 60% of additional generating capacity built over the next six years in Europe will come from alternative generating sources. In addition, the study believes that about 25% of natural gas generating plants in Germany will close between now and 2015. The study also states that 130,000 MW of gas plants, or around 60% of total European gas-fired production, are not currently recovering their fixed costs and are at risk of closing by 2016.

The economics is simple: if a utility cannot recover their fixed costs, investment in new generating facilities will cease.

In the US, there is a growing situation of negative pricing for power. This happens when the grid is full of energy and cannot accept additional power. For Exelon (NYSE:EXC), its nuclear plants in western Illinois currently operate 15% of the time in negative pricing models. As wind and solar power are legislatively preferred sources and take precedence over other fuel-generated power, and as wind and solar capacity continues to expand, negative pricing will become a larger issue for electric utilities.

The following two graphs come from a study (pdf) published in Sept 2012 by the Northbridge Group and Harvard University titled, "Negative Electricity Prices and the Production Tax Credit":

It should be clear that as the percentage of demand is satisfied by wind-generated power, the percent of hours with negative pricing models increases. The conclusion segment of the study is quite revealing:

Based on the evidence presented in this paper, it is apparent that the distortionary incentives and bidding practices caused by production-based wind subsidies, in particular the PTC (production tax credits), have caused high prevalence of negative prices in recent years. These PTC-distorted price signals create a range of near- and long-term problems for electricity markets. The PTC subsidy for wind generation artificially dilutes the incentives for conventional generation - generation that is critical for maintaining reliability. While the PTC was originally intended twenty years ago to jump-start a nascent wind industry, the wind industry today is a full-scale global industry and the PTC's primary effect in the current environment is to distort and disrupt incentives for the electricity industry as a whole.

Our findings lead us to conclude that the PTC should be allowed to expire under current law. PTC-driven negative prices directly conflict with the performance and operational needs of the electric system and with federal energy policies supporting well-functioning competitive wholesale markets. We urge policymakers to: (1) reconsider a national energy policy based on a tax incentive so large it provides wind producers with an incentive to pay system operators to take their wind power; (2) address the reality that wind energy, while an important part of the energy mix, remains unpredictable and cannot be relied upon, especially during periods of high demand; and (3) ensure policies promoting wind do not undermine the conventional technologies that are needed to maintain reliability.

So what are electric utility investors to do?

The main areas of wind and solar generation are in the Midwest, Texas and California. The southeast historically has been a poor choice for alternative energy production. This creates the opportunity for investors to focus on geographical areas where the disruptive nature of alternative energy has the least impact.

Investors who do not currently own Southern Company (NYSE:SO), Duke Energy (NYSE:DUK), Dominion Resources (NYSE:D) and Scana (NYSE:SCG) should consider buying these firms. While SO has some short-term issues with construction projects and DUK has had some regulatory pushback to its merger with Progress Energy and management changes, these firms stand up as some of the best long-term electric holdings for investors concerned about the Europeanization of US utilities.

And if you are not concerned about the Europeanization of US utilities, you should be.

Author's Note: Please review important disclaimer in author's profile.

Disclosure: I am long D, EXC, SO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.